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Cabin Fever

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If in springtime thoughts turn to love, by late summer hearts yearn for real estate. After a week watching the sun set over the Gulf of Mexico or red-tail hawks soar over Big Sur, it's only natural to dream of doing it all again next year. And over the holidays. And long weekends. Heck, why not every weekend?

It's little wonder that August kicks off the prime season for buying vacation homes. More than 1 million people did so last year, making 2005 a record-setter for vacation-property sales. As the real-estate market cools, many would-be buyers sense the time is right to make a deal. But realtors and financial planners caution that vacation-home purchases are often motivated more by emotion than sound judgment, and that buyers need to factor in several key differences between a primary residence and a vacation home in order to assess the true cost of that lakeside cottage.

As a model of fiduciary due diligence, John Leinart would be hard to top. The director of human resources at John Deere in Moline, Illinois, Leinart was an economics major at Notre Dame, and it shows. He and his wife own a vacation condo on the Alabama coast and are currently building a second vacation home in eastern Tennessee. In both cases, he says, "we used a scoring system that assigned points to every potential property based on capital outlay, maintenance costs, and future value. And we broke the maintenance category into four areas: taxes, insurance, fees, and general-maintenance expenses."

That approach, Leinart says, allowed them to rank various options, but he admits that the system goes only so far. "The numerical score accounts for 50 percent of the total," he says. "The other half includes everything from the beauty of the surroundings to access to services like health care and an airport."

Such analysis, Leinart says, revealed that ongoing costs for a condo on the Gulf Coast of Alabama would be only half those for a unit in neighboring Florida. Ditto for the house now under construction at the Estates at Norton Creek in Tennessee as compared with nearby North Carolina. "We looked for 2 to 3 years before we bought in Tennessee," Leinart says, "and for 10 years before we bought in Alabama."

Your search may not take years, but don't reach for the checkbook without asking some hard questions. First, of course, is whether you can afford it. While there is no magic metric, the National Association of Realtors says the typical vacation-home buyer was 59 years old and earned $120,600 in 2005, suggesting that accumulated assets play a big role in a purchase. Given current market conditions, some experts are sounding an alarm against being overinvested in real estate. "It's been hard to make a mistake in real estate over the past 5 to 10 years," says financial planner Doug MacGray of Andesa Strategies Inc. in Wilmington, Delaware, "but that may be changing. I caution people primarily against having an unbalanced portfolio and jeopardizing retirement goals."

One key aspect of affordability is intended use: if you plan to recoup some of your costs by renting the home to others, you'll face a number of tax and related issues that are, depending on your point of view, opportunities or liabilities. There are three basic options. Rent the property for two weeks or less and you pay no taxes on the income, but you also can't claim any deductions against that income. Rent it out more often but still enjoy "significant personal use" (defined as more than 14 days a year or 10 percent of the number of days the house is rented, which is greater) and you'll have to declare the rent as income, but you can also take deductions against it. If you own the house primarily as an investment and rent it all or most of the time, you again pay taxes, can claim deductions even in excess of the income, and may be able to carry losses forward. The first two examples qualify the house as a "personal residence," meaning that you can deduct mortgage interest as long as you're under the $1 million mortgage debt threshold (which can be applied to two personal residences).

Insurance. Expect to pay a lot, because the very things that make a vacation home appealing — proximity to water, remove from civilization — also make it riskier to insure. "If you buy a home in an area that insurance companies don't want to touch," says Carolyn Gorman, a vice president at the Insurance Information Institute, "you could be forced into a high-risk, state-run pool where the rates could start at $3,000 to $4,000 a year."

That's rare, but a little research will reveal whether insurers are pulling up stakes or raising rates. Gorman and her husband pay about $2,500 a year for a vacation home they built on the banks of the Potomac River: $350 for federal flood insurance (which covers only up to $250,000 in damages), $650 for supplemental flood insurance from a private insurer, and $1,500 for normal coverage. Fees for "normal" coverage tend to be higher for vacation homes in part because they are at greater risk for vandalism and other ills that tend to befall homes that are not occupied full-time.

Maintenance. When Beth Shaw bought a vacation home in Palm Springs, California, last year, the founder and president of YogaFit Inc. encountered a problem common to those who rent their second homes: tenants break things. Worse, Shaw's cleaning service did a poor job of maintaining the property. "They put laundry away while it was still wet," Shaw says, "or left the TV or stove fan on, sometimes for weeks with no one in the house." All in all, she says, it can be hard to take care of a house that is hours away from where you spend most of your time. Property-management companies will do everything from lawn maintenance to security for a monthly tab of $100 to $200, but quality varies.

Estate issues. Families tend to develop a deep attachment to their vacation homes, but those happy memories can quickly sour when the house is left to children who have very different ideas about how and when to use it. "I just got off the phone with a client who inherited one-sixth of a vacation home," says MacGray. "The legacy implications of these houses can really hamstring the kids."

Susan Gell Meyers, an attorney at Warner Norcross & Judd in Grand Rapids, says that parents should address two issues: how to leave the house to their children, and how to draft an agreement setting out rules and procedures for joint ownership and maintenance. While the transfer can be handled in a routine will, using a trust or creating a limited liability company offers tax and other advantages.

Regardless of which method is used, drafting an agreement that spells out ownership rights and responsibilities, procedures for divesting a portion of ownership, and other issues can prevent intense squabbling. But harmony doesn't come cheap: Meyers says you should expect to pay $2,000 to $15,000 in legal fees. If you'd like the house to stay in the family, it may be money well spent.